My last article considered just one of a number of ways in which defined benefit and defined contribution arrangements are treated differently from a pension tax legislation perspective. The aspect covered was the pension input amount for annual allowance purposes and showed there was less than equal treatment between the two arrangements.
On the flipside, one area where DC arrangements are more favourably treated is with death benefits.
Pension freedoms opened up opportunities for individuals with DC arrangements to pass significant wealth down through the generations in a tax efficient manner.
Previously, members could nominate a non-dependant to receive death benefits, but it was only in the form of a lump sum. The Taxation of Pensions Act 2014 introduced the concept of nominees and successors, allowing anyone in these categories to also have the choice of taking a pension death benefit; for example, beneficiary’s flexi-access drawdown.
This sea change created something of a chasm between DB and DC schemes in that the former enjoyed no such freedoms and, unless a beneficiary was a dependant, they could not enjoy the option of an income and were only entitled to any lump sum death benefit.
The implication of this is that the lump sum is no longer held in the tax advantageous wrapper of a pension and the value forms part of the estate of the beneficiary.
Where the beneficiary is a dependant there are both positives and negatives.
In the case of the DB arrangements, if the member dies before drawing their benefits there is no benefit crystallisation event associated with the dependant’s scheme pension and therefore no usage of the member’s lifetime allowance.
If there was death in service lump sum payable through the pension scheme, there would likely be a BCE 7 for the lump sum, but unless the individual has other pension savings elsewhere it is hard to envisage many scenarios in which an LTA charge would arise solely through the payment of this benefit.
The major downside to any dependant’s scheme pension is that the benefits are liable to income tax.
In the case of DC arrangements, the tax treatment of the death benefits is dependent on a number of factors, including the age of the pension holder and, on the death of the original member, whether the funds are crystallised or not.
Where funds are uncrystallised they are potentially tested against the member’s LTA to determine whether any LTA tax charge is payable. In respect to the income tax treatment of the death benefits the main issue is whether the pension holder was under 75 at the time of their death. If they were – and subject to certain conditions for nominees’ benefits being met – the death benefits are tax free either if taken in the form of a lump sum or as income, or indeed any combination of these.
In the vast majority of cases, given how recently pension freedom legislation was introduced, scheme administrators are still wrestling with the concepts of passing on DC pension funds to nominees.
The following example will help show the differing treatment between DB and DC death benefits.
Richard and Roger, two retired architects, both worked for the local authority. Before moving into private practice, Richard had become chief architect for the authority and Roger was his deputy. Roger, a married father of two adult daughters, took over when Richard moved. Richard is a widower with two adult sons.
A number of years after leaving the local authority, Richard transferred his final salary scheme to a Sipp and he and his company continued to fund that arrangement.
Roger remained a member of the final salary scheme throughout his career. Both applied for fixed protection in 2012 when they were 65 and retired shortly after having fully crystallised all their benefits.
Sadly, Roger recently passed away, leaving a widow Sue, who herself is in poor health.
Roger – DB arrangement
Roger’s initial pension benefits in 2012 were an index-linked pension of £65,000 per annum, making him a high rate taxpayer, plus a £195,000 pension commencement lump sum.
On his death, the death benefit payable (scheme rules will dictate benefits) were a £32,500 pa index- linked pension for Sue, which is taxable as income, plus a possible lump sum (assessed against Roger’s LTA through a BCE 7).
On Sue’s death the pension will cease and their daughters will not be entitled to any benefits.
Richard – DC arrangement
Richard’s fund in 2012 was worth £1.8m, allowing him to take a PCLS of £450,000. He then managed his income within the basic rate band initially through capped drawdown and now flexi-access drawdown, topping up through other savings such as his Isa. As a result his drawdown fund is worth just under £1.35m.
If Richard dies before 75, his whole fund passes tax free to his two adult sons as nominated beneficiaries. If they elect for beneficiary’s drawdown, they can draw a tax free income and in turn pass the funds to beneficiaries of their own choosing.
The ability to cascade DC funds down through the generations in this tax efficient manner is what appeals so much compared with the finite outcome with DB arrangements.
For high net worth clients that are also members of DB schemes this is particularly so and one of the drivers when considering transferring DB arrangements.
The difficulty for the adviser is in trying to square the circle between what the client thinks is the optimum solution and what the adviser knows from experience.
Neil MacGillivray is head of technical support at James Hay